The form of incentive contracts: agency with moral hazard, risk neutrality, and limited liability

Abstract

The analysis obtains a complete characterization of the optimal agency contract with moral hazard, risk neutrality, and limited liability. We introduce a “critical ratio” that indicates the returns to providing the agent with incentives for effort in each random state. The form of the contract is debt (a capped bonus) when the critical ratio is increasing (decreasing) in the state. An increasing critical ratio in the state‐space setting corresponds to the hazard rate order for the reduced‐form distribution of output, which we term the “decreasing hazard rate in effort property” (DHREP). The critical ratio also yields insights into agency with adverse selection.

Can Agents Be Better Off with Pay Caps?

“…and Spulber [23] extend the result of Innes [12] by allowing for a larger class of outcome distributions. In addition, Jewitt et al [14] offer a general characterization of an optimal incentive contract when there are both lower and upper bounds for payments, and prove the important results of existence and uniqueness.…”

“…We further examine the effect of improved contracting information on the cost of the pay cap and find that although improved contracting information always reduces the cost of the pay cap, it may increase the marginal cost of it. Our result should provide a new perspective for considering numerous issues discussed in the literature that arise under limited liability, such as monitoring in Demougin and Fluet [8] and Schmitz [27], task scheduling in Mylovanov and Schmitz [20], the form of optimal contract in Innes [12], Kim [16], and Poblete and Spulber [23], or performance standards in Sherstyuk [29].…”

How Patents Provide the Foundation of the Market for Inventions

“…Jensen and Meckling (1976) argue that with moral hazard, debt financing gives managers incentives for more efficient performance in comparison to equity financing. Poblete and Spulber (2012) show generally that the optimal contract with moral hazard and limited liability takes the form of debt. This is because debt-style contracts serve to concentrate payments to the agent in the best states, which induces efficient levels of effort.…”

Management of Knowledge Workers

“…In the special case where the agent's outside option is constant (i.e., = 1) and the …rm sues, results from Poblete & Spulber (2009) apply. They show that if the hazard rate of g( ) is decreasing, the optimal wage contract is a call option on output.…”